In Defense Of Mutual Fund DSC Fees For Smaller Investors

by Mike Holman

One common complaint when it comes to mutual fund fees, is a general hatred for DSC (Deferred Sales Charge) load mutual funds. While I understand that nobody likes paying fees, I also think that this fund load is misunderstood and can be beneficial for smaller investors who invest through an advisor.

What are DSC fees and how do they work?

When you buy a DSC mutual fund from an advisor, you don’t pay any kind of direct sales fee. Instead the mutual fund company will pay the advisor an upfront sales fee – usually around 5%. This way all of your money gets invested and your advisor gets some payment.

The catch is that these funds have a DSC fee schedule which usually start at around 6% and last for approximately 6 years. The fee will decline each year until it gets to zero. The DSC fee is only applied to investors that sell their mutual fund units before the DSC schedule has finished.

Here is a sample DSC schedule:

Year

% Fee

1

6.0

2

5.0

3

4.0

4

3.0

5

2.5

6

1.5

7

0

If you were to sell your mutual fund in year one, the DSC fee would be 6.0% of the investment amount. If you wait until year 4 to sell, the DSC fee would be 3.0% of the sale amount. Note, that some companies will calculate the fee on the original purchase amount.

The problem is that most people who buy DSC funds are not aware of how DSC fees work and consequently get upset if they sell their funds and get nailed with unexpected fees.

Why DSC fees are not as bad as you think (and ways to reduce the fees)

1) Advisors need to get paid

If you want to use a financial advisor then you have to pay them. It takes time for an advisor to meet with you, get an account set up and handle the paperwork and transactions. DSC load funds allow smaller investors to avoid paying direct fees and enable them to get all their money invested.

Trailer fees are not enough. Trailer fees are fees – usually 0.5% to 1.0% per year which are paid to the advisor from the mutual fund. These can be very lucrative for larger accounts, but for a small investor – they don’t add up to squat.

The alternative to DSC funds for a small investors is direct fees. For example, an advisor might charge $100 to set up an account.

2) DSC fees are not applied to switches between funds at the same fund company

If you own XYZ Growth Fund and you want to switch over to XYZ bond fund, then you should be able to make that switch without paying any DSC fees. The original DSC schedule should carry over to the new fund.

Of course this means you can’t leave that particular fund company without paying DSC fees, but you are not locked into any single fund.

3) DSC fees go down over time

If you wish to withdraw your money from a DSC fund, phone the fund company to find out how much the DSC charge will be. If you’ve had the account for a while, then you won’t be paying the maximum charge.

4) 10% free option

Most fund companies have an annual 10% free withdrawal for DSC funds. What this means is that you can take 10% of the fund value (as of the beginning of the year) and switch it to a non-DSC version of the fund. Or you can just redeem the 10% amount if you wish.

This is something that you have to request every year, but the more DSC load units you can switch to non-DSC load, the lower the DSC fee will be if you sell the fund.

5) Negotiate the DSC charge

While the basic DSC fee can’t be changed, you can sometimes negotiate with your advisor to reduce the amount of fee that the advisor keeps. Any difference will be deposited in your account as a new purchase.
For example if the DSC fee is 5% and your advisor agrees to reduce her commission to 3%, then the 2% difference will be placed in your account.

This leads to the interesting situation of a “cash-back” purchase where you end up with more money in the account than you deposited. In the example above, you would end up with 102% of your original purchase.

This is typically used when an investor is moving money from one fund company to another and is hit with DSC charges on the sell side, however it will work for any purchase.

The amount you have to invest will help determine your success with this strategy. The more money you have, the more leverage you have.

6) Timing of the sell

Check with your advisor or fund company to see if the DSC fee will drop significantly if you wait a bit. If you made a large purchase to open the account and you are close to a lower level in the fee scale, it might be worthwhile to wait.

Please note, that these rules are general. Phone your advisor or fund company to verify the exact fund company rules before doing anything.

Should I wait to convert my expensive funds to cheaper index funds?

No.

If you own an expensive mutual fund with a 2.50% annual MER and wish to switch to a cheaper fund which has a 0.5% annual MER, then you will save 2.0% per year. As long as you stay invested in the cheaper fund for at least a few years, then the annual savings will quickly outpace any DSC fee.

Should mutual fund DSC fees be banned?

The main problem with DSC fees is the lack of disclosure. Most financial advisors “sell” mutual funds and DSC fees are not a good sales pitch. A friend once told me that an advisor tried to get him to invest his house down payment savings in DSC equity mutual funds. That kind of advice is as bad as it gets.

If DSC load funds were banned, then it is likely that no money will be saved by investors. Here are some things which might happen – especially for smaller investors:

Front load fees more likely to be charged. These are fees which will apply to the sale price and will come out of the investment amount.

Want to learn more about RESPs? Buy The Book:

Good post, Mike. I’m the last person to be an apologist for the advisory industry, but as you point out, if you want the services of an advisor, you have to expect to pay for it. And most consumers are unwilling to write a cheque to their advisor the way they would for a lawyer or accountant. Ask some fee-only advisors how hard it is to make people understand that advice costs money.

It’s also important to remember that before DSCs appeared, it was customary for mutual fund companies to charge 9% front-end loads! For long-term investors who genuinely need the services of an advisor, the DSC model is vastly superior to that, as long as it is fully explained.

Given that investors seem to believe that they don’t pay their advisors at all, my complaint about DSCs, front-end loads, and MERs is all the same: explain them to investors in a way they can understand them. The real measure of which type of fees are better comes down to how much money the investor pays.

The first is that you’re essentially locking yourself into a relationship for a number of years with someone that you can only do a limited amount of research on in the first place. So if they answer the questions well and seem to be a good sort the novice investor will sign on, and then if the relationship changes or sours it’s pretty darn difficult to get anything useful out of the situation for several years. (10% per year is still leaving half your money there for the full period and getting none of the advice you hoped for) At least a fee only advisor or a no-load scheme has no ties to break.

The other issue I personally have relates to human nature itself and the reward behavior promoted by DSCs. As mentioned, trailer fees are piddly amounts for small accounts – so the greatest reward for an advisor comes from the commission fees. For most people, it is only logical to devote the most effort to the pursuits that win them the most compensation. For an advisor in this scheme, the most optimal pursuit is to lock in as many clients as possible while letting existing clients slide. Sure – some advisors will realize that a stable of happy clients generates more long-term income than a constant rotation, but in the short term DSCs (and Front Loads too) reward salesmanship over service.

Being a former commission based advisor, I think advisors deserve to get paid. That being said, I’ve always preached that it’s about VALUE. Advisors need to justify their VALUE. What are they doing to deserve to get paid? Put financial plans together? meet with clients annually? Research? Good advisors know their value and are not afraid to disclose but also justify their compensation!

@Michael – I agree that the total fees paid is the proper measure. One problem is that fees don’t help sell financial products, so advisors don’t like talking about them. The other problem is that if an investor thinks they are getting financial advice for free, they don’t want to know about the costs because they think it doesn’t concern them (even if it does).

@Jak – That’s not the way DSC funds work. If you buy DSC funds with one advisor, you can then get a new advisor and transfer over your existing funds to the new advisor. You are not locked into that advisor in any way.

As for your 2nd point – Yes, the financial advice industry in Canada (and elsewhere) is 100% driven by sales. That’s why investor education is so important.

Mike
Thanks for link! One thing that could perhaps be added is that DFCs are still fees embedded in the product. Advisors deserve to be paid of course, but this approach can lead to advisors recommending funds according to how much they pay out as opposed to whether or not they are actually good for the client. Second, there is a good argument for viewing DSCs and trailer fees as kickbacks to salespersons versus payment for services rendered (as a recent academic study argued). Specifically, many mutual-fund salespersons will feel a duty to provide service to their clients but others will neglect existing clients (especially the smaller ones) and be more focused on getting new sales (and meeting company quotas).

Mike, you probably want to do an article on “low load” funds. Advisors like to sell those as well. Different companies have different “low load” schedules. I read that Fidelity has 2% upfront commission paid by the fund company, .5% trailing commission, and the fund is locked for two years. I heard that AGF pays 2.5% upfront commission to the brokerage, .5% trailing commission, and the fund is locked for three years.

My biggest critique about DSC or Low Load Funds is that it is incompatible for people who are seeking the best portfolio managers in active managed funds. The best talents often switch companies after establishing their record. If the manager leaves, the person is stuck with the fund because of DSC or Low Load charges.

In economics, I was taught that transparency about price is very important in making good decisions. I find that DSC or Low Load Funds lack the transparency on the price that you are paying for the financial advise. If people think that are not paying for advise, then people will not demand advise from their financial advisors. Thus, financial advisors can get with receiving commissions and not providing advice.

I don’t think the problem is with A, B & C shares, but rather the lack of disclosure involved by a number of poor advisors.

Personal Finance Bloggers (not you Mike) are quick to state that fee based is the only way to go, but don’t really go into the obvious problem of how many people are actually willing to write the check.

Quick question, if you have been contributing monthly to a fund with deferred sales charges for, let’s say over 6 years in your example above, can I only withdraw the amount I’ve had invested over 6 years without paying any fees? Alternatively, I suppose one can use the 10% option if that amount is greater.

Hi now isn’t there some sort of oath taken by advisors where they need to provide all information available including the DSCs. And if not how do reps sleep at night bye not letting the investor know about these fees (especially the not so rich clients). Just currious is all as I am a fairly new investor working in the financial industry